postings by Michelle Harner

Signing Off with a Bankruptcy Case Made for TV

posted by Michelle Harner
I thought I would wrap up my week of blogging with a little entertainment—the Trump Entertainment chapter 33 case.  Yes, this is Trump Entertainment’s third trip through chapter 11 of the U.S. Bankruptcy Code, and its adventure rivals any episode of Survivor, The Amazing Race or even The Apprentice.

Trump Entertainment’s first chapter 11 filing occurred in 1992 on the heels of the 1990-91 recession.  Although Donald Trump lost control of the company after the bankruptcy, he was able to maneuver his way back in (see here).  Nevertheless, his luck appeared to run out again in 2004, when the company filed its second chapter 11 case, forcing Mr. Trump to significantly reduce his holdings in the company and resign his executive position.  (Mr. Trump cited numerous causes for the second filing, including “competition and fuel prices” (see here).)  But it appears that Mr. Trump may be back in the game again.

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Courts are Signaling, but is Congress Listening?

posted by Michelle Harner

As I previously mentioned, recent amendments to the U.S. Bankruptcy Code have been significant and driven in large part by special interest groups.  Yet, Congress has ignored ambiguity in the Code that has persisted for years, causing confusion, uncertainty and additional expense in numerous chapter 11 cases.  One prime example is section 365 of the Code; in particular, sections 365(c) and (n) in the context of intellectual property licenses.

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Discussing the “B” Word with Corporate Boards

posted by Michelle Harner

Countless restructuring lawyers have told me that their corporate partners are hesitant to introduce them to their firm’s troubled business clients because the “B” word might “spook” the client.  I also experienced board ostrich syndrome (i.e., denial that the company is experiencing financial distress) first-hand at several points during my days in private practice.  Moreover, if and when lawyers finally discuss the “B” word with a company, it most always is pitched as a last resort option.

It is against this backdrop that I recently read and considered the Delaware Chancery Court’s decision in Binks v. DSL.net, Inc.  The question before the court was whether the business judgment rule protected the decision of DSL.net’s board to cause the company to incur additional debt, rather than file for bankruptcy.  (For a concise summary of the case, see here.)  The board’s decision was contested by one of DSL.net’s minority shareholders because the additional debt included convertible notes that, once converted, gave the lender a 90% ownership stake and the ability to consummate a short-form merger.  The court ultimately concluded that the board was independent, disinterested and well-informed, and consequently protected by the business judgment rule, even under the more exacting standard of Revlon and its progeny.

I do not disagree with the court’s conclusion. (For a general discussion of when heightened scrutiny of control transactions might be warranted, see here.)  Anyone who has been inside a boardroom during these types of deliberations understands the complexity of the situation; the multiple, often-competing considerations; and how even the most well-intentioned, diligent and intelligent board may make a decision that turns out to be suboptimal in hindsight. I do wonder, however, whether we are performing a disservice to corporate clients when, almost as a matter of course, lawyers and corporate executives shun bankruptcy and fail to include the chapter 11 option in normal risk management and strategic discussions.

We should be even more concerned about this approach when you consider the possible cognitive biases that might affect the board’s decisionmaking (see, e.g., here, here and here).  For example, loss-framing causes individuals to be more risk-preferring when they are facing two or more choices that all present a risk of loss (see, e.g., pp. 1127-1130 here).  The risk might be bigger, but so too will be the reward for the company and its shareholders, or so the thinking goes.  Likewise, overconfidence and “the Lake Wobegon syndrome” can cause executives to believe that, regardless of the facts, they somehow will avoid disaster and pull their company back from the brink. (For a general discussion of cognitive biases and risk management, see here.)  Decisionmaking biases and the general aversion to bankruptcy could be a lethal combination for a troubled company.

Seen this Movie Before?

posted by Michelle Harner

For the past several years, we have watched various industries struggle, including the automotive, airline and entertainment industries. Although troubled companies within these industries have their own unique issues, they also share common experiences relating to the recent recession, competition and product/technology obsolescence. Recessions and in turn bankruptcy often are said to facilitate creative destruction, but I actually like a phrase recently used by Chrysler’s CEO, Sergio Marchionne, "creative reconstruction."

U.S. bankruptcy laws—in particular, chapter 11—give companies an opportunity to recreate themselves. In this sense, creative reconstruction might be a more apt phrase for the utility of chapter 11 (see my previous post on that topic here). A company can use the chapter 11 tool not only to reorganize its capital structure but also to streamline or transform its operations (e.g., eliminating outdated product lines or technologies). In those instances, the protection of the automatic stay, the flexibility of the executory contract and lease provisions and the time granted companies to reorganize are critical. It is here that the 2005 amendments to the U.S. Bankruptcy Code arguably weakened the utility of chapter 11 for many companies.

Rather than rehash the issues created by the 2005 amendments, I would like to focus on the potential for creative reconstruction in chapter 11. And I would like to do so by reflecting on the recent experiences of Movie Gallery and Blockbuster. Both companies incurred significant debt as the result of M&A activity during 2004 and 2005 (see, e.g., here for Movie Gallery and here for Blockbuster). Both companies faced increased competition from new technologies and new market entrants (Netflix, Redbox, etc.). And now only one company remains, but it too is on the verge of extinction.

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Private Funds and Bankruptcy

posted by Michelle Harner

As the financial reform bills make their way through committee conference, I thought I would take this opportunity to reflect on the activities of private equity firms and hedge funds in bankruptcy. (For those of you interested in the bills’ efforts with respect to credit rating agencies, see my post here at Maryland’s new faculty blog.) Although the financial reform bills provide for some regulation of private funds (see here and here), some argue that the proposed measures are meaningless because of, among other things, exemptions and enforcement issues (see here and here). Others argue that even these measures hinder private funds’ business models (see here). Irrespective of your views on this debate, it is clear that the bills do not address the challenges posed by private funds in the distressed debt context.

Investing in distressed debt is not a new investment strategy, but private funds have been pursing it with increased vigor in recent years. And they have been doing so quite successfully. These funds generally yield above-market returns, and during the 1999-2004 economic bubble/burst, they averaged "double-digit returns, including 30 percent for the 2002 funds." The most recent recession has likewise provided ample opportunity for distressed debt investors. These opportunities are likely to continue for the next several years, as "U.S. companies have about $600bn . . . of leveraged loans to refinance . . . between 2011 and 2014."  (See here and here.)

Distressed debt investing generally involves a private fund purchasing the debt of a troubled company and then exploiting the leverage associated with that debt instrument when the company defaults or is about to default on the underlying obligation (see here and here). Some of these investors resemble pure traders and primarily seek to flip the debt for a quick return. Others are, however, using this investment strategy to influence corporate governance or make a control play for the company. (For data on investment strategies, see here.) These investors also are increasingly willing to extend postpetition loans (i.e., DIP financing) to troubled companies, often with the intent to credit bid the debt or otherwise convert it into equity to gain control of the company. As one commentator observed, "Investors in loan-to-own deals may earn an 18 percent return on the financing, plus get equity, compared with the potential for 12 percent returns and no equity on DIPs."

Now, I am not against private funds earning positive returns for their investors—that is of course the primary objective of for-profit endeavors. I also believe that these investors frequently provide much-needed liquidity to troubled companies; liquidity that otherwise would be unavailable and that can provide a second (or third, etc.) chance for the company to the benefit of all stakeholders. I am, however, concerned about the unlevel playing field on which these investors operate in many instances.

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The Utility of Chapter 11

posted by Michelle Harner

First, I want to thank Bob Lawless and the other authors of Credit Slips for inviting me to guest blog this week. I am honored to share this space with you, and I look forward to a robust dialogue.

Second, I have to say that guest blogging at Credit Slips feels like coming home to me. Before changing careers, I had the privilege of serving as a law clerk to the Honorable William T. Bodoh, and I practiced as an associate and then a partner in Jones Day’s corporate restructuring practice group for about ten years. I welcome this opportunity to share my passion for everything bankruptcy with others interested in the field.

As you might suspect from my days in practice, I am a strong proponent of the utility of chapter 11 of the U.S. Bankruptcy Code as a restructuring tool. I want to emphasize that I view chapter 11 as a "tool"—not a "fix"—in the context of financial distress. The effectiveness of this tool depends largely on who is using it and how it is being used. Companies do not fail because of chapter 11; rather, companies fail because, among other things, they wait too long to invoke the chapter 11 tool (see here), they do not understand how best to use that tool (see here), or perhaps they simply have outlived their economic utility (see here).

The effectiveness, however, also depends on the construction of the tool itself. So how do we assess its construction? Although there are a number of very useful studies on the topic, I suggest we look back at the origins of chapter 11 and three of its important features: its dual goals of rehabilitation and value maximization (referenced recently here in Congressional testimony); its design to mitigate the collective action problem (see here at pp. 95-98 for an interesting discussion); and its ability to promote negotiation and consensual resolution.

The dual goals of rehabilitation and value maximization require transparency and information sharing to all, and by all, key constituents. The collective action problem merits strong rules maintaining the status quo while constituencies gather around the negotiating table. And negotiation needs a flexible framework and a neutral third party with the discretion and power to adapt the rules to the particular needs of the case. Does chapter 11 currently measure up?

Over the years, chapter 11 has increasingly moved away from its original objectives and, in many respects, been captured by special interest groups. This shift has created weaker rules and less flexibility. It also has limited the contributions of our specialized and very talented bankruptcy bench.

During my time at Credit Slips, I hope to explore the strengths and weaknesses of chapter 11 in its current state, including its role in facilitating obsolescence (see here), creating value and exploiting information asymmetries (see generally here and here). Chapter 11 has changed and perhaps not all for the best. I suggest that we might best move it forward by looking backward.

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  • As a public service, the University of Illinois College of Law operates Bankr-L, an e-mail list on which bankruptcy professionals can exchange information. Bankr-L is administered by one of the Credit Slips bloggers, Professor Robert M. Lawless of the University of Illinois. Although Bankr-L is a free service, membership is limited only to persons with a professional connection to the bankruptcy field (e.g., lawyer, accountant, academic, judge). To request a subscription on Bankr-L, visit http://listserv.uiuc.edu/archives/bankr-l.html and click on the link for "Join or leave the list." After completing the information there, please also send an e-mail to Professor Lawless (rlawless@illinois.edu) with a short description of your professional connection to bankruptcy. A link to a URL with a professional bio or other identifying information would be great.

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